A Year After the Financial Crash by Niall Ferguson

Since its birth, the United States has grappled with the problem of an over-mighty financial sector. With the exception of Alexander Hamilton, the Founders' vision was of a republic of self-reliant farmers and small-town tradesmen. The last thing they wanted was for New York to become the London of the New World—a mammon-worshiping metropolis in which financial capital and political capital were rolled into one. That was why there was such resistance to creating a central bank, and why—despite two attempts—we have no Bank of the United States to match the Bank of England. That was why populists railed against the adoption of the gold standard after the crash of 1873. That was why there was so much suspicion when the Federal Reserve System was created in 1913. That was why government regulation of Wall Street was so strict from the Depression until the 1970s.

But now, barely a year after one of the worst crises in all financial history, we seem to have returned to the Gilded Age of the late 19th century—the last time bankers came close to ruling America. A few Wall Street giants, led by none other than -JPMorgan, are back to making serious money and paying million-dollar bonuses. Meanwhile, every month, hundreds of thousands of ordinary Americans face foreclosure or unemployment because of a crisis caused by … a few Wall Street giants. And what makes the losers in this crisis really mad is the fact that there's now one law for the small debtors and another for big ones. If you lose your job and fall behind on your $1,500 monthly mortgage payment, no one's going to bail you out. But Citigroup can lose $27.7 billion (as it did last year) and count on the federal government to hand it $45 billion.

A hundred years ago, people angrily compared the House of Rothschild to a giant octopus with its tentacles wrapped around the U.S. economy. Today it's the turn of Goldman Sachs to be likened to a "great vampire squid." To understand why, you need to go back 12 months.

With the bankruptcy of Lehman Brothers Holdings Inc. last September, 9/15 supplanted 9/11 as the costliest day in the history of New York City. It was also the most cataclysmic American bank failure since 1931.

The Lehman bankruptcy was in fact only one of seven events that, in the space of just 19 days, signaled the end of an epoch. On Sept. 7, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac) were nationalized. On Sept. 14, Merrill Lynch was bought by Bank of America. On the same day that Lehman failed, the money-market fund Reserve Primary "broke the buck" because of losses on unsecured commercial paper it had bought from Lehman. The next day—to avoid a lethal chain reaction in the market for credit default swaps—the insurance giant AIG was given an $85 billion bailout by the Federal Reserve. On Sept. 22, the investment bank went extinct as a species when Goldman Sachs and Morgan Stanley converted themselves into bank holding companies. Finally, on Sept. 25, Washington Mutual was placed into the receivership of the Federal Deposit Insurance Corp. (FDIC).

Not everything that has gone wrong in the world economy since 2007 can be blamed on these seven events, much less on the Lehman bankruptcy alone. At most, about a fifth of the total 50 percent decline in the U.S. stock market between the peak of October 2007 and the low of March 2009 could be attributed to what happened in September of last year. (October 2008 was an even worse month for stocks.) But other indicators better reveal the scale of the financial trauma. In the 24 hours after Lehman failed, the London Interbank Offered Rate (LIBOR, for short)—the rate that financial institutions charge each other for unsecured borrowing—soared 3.33 percentage points, to 6.44 percent. The commercial-paper market froze. The resulting credit crunch set off a chain reaction. Firms canceled orders and started laying off workers. International trade collapsed.

Equally dramatic—and more long-lasting—has been the effect of the crisis on government policy. Prior to 9/15, it seemed unlikely that Congress would approve a large-scale bailout for Wall Street. Treasury Secretary Henry Paulson had told potential buyers of Lehman Brothers there would be "no government money" to sweeten any takeover deal. Even after the Lehman failure, it still took two attempts to secure passage of the $700 billion Troubled Asset Relief Program through Congress. Since then we've witnessed the fiscal equivalent of a dam bursting. We're now looking at $9 trillion of new federal debt in the decade ahead.

Prior to 9/15, the Federal Reserve Board argued that the Fed could not buy "shaky assets" from Lehman, but could only lend against "good collateral." In the week that followed, the Fed's balance sheet leapt upward by 21 percent after the institution announced it would accept equities as collateral for the first time in its history. Other new measures included the FDIC's guarantee of all bank debt—a remarkable undertaking given the quantity of bonds issued by U.S. banks.

Six months earlier the Treasury and Fed had saved Bear Stearns from bankruptcy by brokering its sale to JPMorgan Chase. Though shareholders and bondholders had lost money, they had not been wiped out completely. By treating Lehman differently, the authorities shattered the illusion that some major financial institutions were "too big to fail." But starting with the bailout of AIG just a day later, they quickly began the expensive process of trying to restore that illusion. Now it's no longer an illusion. It's become a very dangerous reality.

In April this officially became the longest recession since World War II. The International Monetary Fund expects the U.S. economy to shrink by 2.6 percent this year. The unemployment rate is heading for 10 percent. With numbers like that, you'd think some radical reform was in order. But no. Despite much talk on both sides of the Atlantic of new financial regulation, the likelihood is that the most important flaw in our financial system will not be addressed. On the contrary, the emergency measures taken a year ago have made it significantly worse. That flaw can be summed up in a single phrase: banks that are "too big to fail." Let's call them the TBTFs.

Between 1990 and 2008, according to Wall Street veteran Henry Kaufman, the share of financial assets held by the 10 largest U.S. financial institutions rose from 10 percent to 50 percent, even as the number of banks fell from more than 15,000 to about 8,000. By the end of 2007, 15 institutions with combined shareholder equity of $857 billion had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion—a total leverage ratio of 23 to 1. They also had underwritten derivatives with a gross notional value of $216 trillion. These firms had once been Wall Street's "bulge bracket," the companies that led underwriting syndicates. Now they did more than bulge. These institutions had become so big that the failure of just one of them would pose a systemic risk.

Last year's crisis made this problem worse in two ways. First, it wiped out three of the Big 15: goodbye Bear, Merrill, and Lehman. Second, because the failure of Lehman was so economically disastrous, it established what had previously only been suspected—that the survivors were TBTF, effectively guaranteed by the full faith and credit of the United States. Yes, folks, now it's official: heads, they win; tails, we the taxpayers lose. And in return, we get … a $30 charge if we inadvertently run up a $1 overdraft with our debit card. Meanwhile, JPMorgan and Goldman Sachs executives get million-dollar bonuses. What's not to dislike?

None of the regulatory reforms proposed so far do anything to address the central problem of the TBTFs. What did Treasury Secretary Timothy Geithner propose over the summer?

• The Fed should become the "system risk regulator" with power over any "systemically important" institutions, a.k.a. TBTFs. But wasn't it that already?

• The originators of securitized products should be required to retain "skin in the game" (5 percent of the securities they sell). What, like Bear and Lehman did?

• There should be a new Consumer Financial Protection Agency. So what were the other regulatory agencies doing? Oh, yes, protecting the TBTFs.

• There should be a new "resolution authority" for the swift closing down of big banks that fail. But such an authority already exists and was used when Continental Illinois failed in 1984.

• And "federal regulators should issue stand-ards and guidelines to better align executive compensation practices of financial firms with long-term shareholder value." I can't wait to hear what those will be.

At the recent G20 finance ministers' meeting the only significant difference was a call for the TBTFs to raise more capital and become less leveraged "once recovery is assured." Even that has elicited protests from the bankers. Before the ink was dry on the G20 communiqué, JPMorgan published a report warning that proposed regulatory changes would reduce the profitability of the investment-banking operations of Deutsche Bank, Goldman, and Barclays by as much as a third.

The compensation issue, by the way, is a red herring. Politicians like to focus on bankers' bonuses, because everyone can be shocked by the fact that Lloyd Blankfein, the Goldman CEO, gets paid 2,000 times what Joe the Plumber gets. But that's a symptom, not a cause, of the deep-rooted problem. The TBTFs are able to pay crazy money because they reap all the rewards of risk-taking without the cost: the risk of going bust. Ask yourself, how did Goldman make those handsome second--quarter profits of $3.4 billion? Yes, by leveraging up and taking on more risk.

Right now we don't need a charade in which politicians claim they are going to regulate the big banks more tightly. (These are the same politicians who were supposed to be regulating Fannie and Freddie, remember.) What's needed is a serious application of antitrust law to the financial-services sector and a speedy end to institutions that are "too big to fail." In particular, the government needs to clarify that federal insurance applies only to bank deposits and that bank bondholders will no longer protected, as they have been in this crisis. In other words, when a bank goes bankrupt, the creditors should take the hit, not the taxpayers.

Do I think we'll get either of these things? For now I don't. The political will is ebbing fast, health-care reform is looming too large, and guess which institutions are among the biggest lobbyists and campaign-finance contributors? Surprise! None other than the TBTFs. Yet if the status quo persists, the danger of a populist backlash against both Wall Street and Washington will only grow. Such a backlash has more than one precedent in U.S. history.

The second Bank of the United States, established in 1816, became the focus of a powerful political campaign against "money power." Though it survived a legal challenge by the state of Maryland, the Philadelphia-based bank fell victim to President Andrew Jackson, who recognized the electoral advantages of an attack on the "monster." When the bank's president, Nicholas Biddle, applied to have its charter renewed in 1832, Jackson vetoed it, vowing: "The Bank is trying to kill me, but I will kill it." Despite Biddle's effort to precipitate a financial panic in retaliation, "Old Hickory" carried the day, and in 1836 the bank lost its public status. Without government backing, it did not last long. In October 1839 the bank suspended payments, and in 1841 it disappeared.

TBTFs, be warned. But Old Hickory, where are you when we need you?